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Tax News and Developments
North American Tax Practice Group
Newsletter Procter & Gamble Washes Away Some Questions
Regarding the Extent of the Foreign Tax Credit
April 2011 | Volume XI-2
“Exhaustion” Requirement
The foreign tax credit, set forth in Code Sections 901 through 908, was designed
In This Issue: to alleviate the double-taxation of foreign-source income. The foreign tax credit,
however, is subject to a number of requirements and restrictions. One such
Procter & Gamble Washes Away
Some Questions Regarding the requirement is that the taxpayer exhaust available remedies in determining the
Extent of the Foreign Tax Credit actual amount of foreign tax owed, such as pursuing administrative appeals in
“Exhaustion” Requirement the foreign country. The IRS scored a recent victory with respect to this
requirement in Procter & Gamble Co. v. United States, 106 A.F.T.R.2d 2010-
California Court Treats Copyright 5311 (S.D. Ohio 2010), in which the District Court denied the taxpayer a full
Royalties as Income from Tangible foreign tax credit on the basis that the taxpayer had failed to exhaust all effective
Property in Microsoft Case
and practical remedies, such as seeking competent authority assistance, when
The Ralphs Grocery Decision two foreign countries imposed tax on the same item of income. Perhaps
Restricts the Ability of Creditors to emboldened by this triumph, the IRS subsequently announced that it would be
be Considered Equity Owners for more closely examining foreign tax credits claimed by multinational taxpayers to
Purposes of the Continuity of determine whether the “exhaustion” requirement has been satisfied.
Interest Doctrine
Chief Counsel Advice Adds More Treasury Regulations promulgated under section 901 set forth the exhaustion
Confusion to Questions Regarding requirement. A foreign levy is a “tax” if it “requires a compulsory payment
Place of Use of Intangibles pursuant to the authority of a foreign country to levy taxes,” as determined by
principles of US law. Treas. Reg. § 1.901-2(a)(2)(i). A payment is not a
Federal Circuit Upholds Regulation “compulsory payment” to the extent that the amount paid exceeds the amount of
Extending Six Year Statute of tax liability under foreign law. Treas. Reg. § 1.901-2(e)(5)(i). Such liability must
Limitations to Overstated Basis
be determined by the taxpayer “in a manner that is consistent with a reasonable
Cost-Sharing “Divisional Interests” interpretation and application of the substantive and procedural provisions of
Rule as Applied to e-Commerce foreign law (including applicable tax treaties) in such a way as to reduce, over
Business Models time, the taxpayer’s reasonably expected liability under foreign law for tax.” This
rule requires that the taxpayer exhaust “all effective and practical remedies,”
Proposed Regs Would Require US
Financial Institutions to Report
including competent authority procedures available under applicable tax treaties,
Bank Deposit Interest Income for all to effect such a reduction. The limiting term “effective and practical” spares
Non-Resident Alien Individuals taxpayers from engaging in herculean efforts in order to obtain the benefits of the
foreign tax credit and requires only that the cost of pursuing such remedies be
First Annual BNA/Baker & reasonable in light of the amount at issue and the likelihood of success. In
McKenzie Transfer Pricing interpreting foreign tax law, a taxpayer may generally rely on advice obtained in
Conference to be held June 8-9 in good faith from a competent foreign tax advisor to whom the taxpayer has
Washington, DC
disclosed the relevant facts.
The Procter & Gamble decision has clarified just how far taxpayers must go in
order to meet the exhaustion requirement. In that case, the taxpayer, a US
corporation, was the common parent of an affiliated group of corporations,
including P&G Northeast Asia (“P&G NEA”), a Singapore corporation that
managed the taxpayer’s Japanese and Korean operations from a principal office
Baker & McKenzie
located in Japan. During the years at issue, P&G NEA paid royalties to the
taxpayer and withheld a 10 percent Japanese tax, but paid no taxes to Korea.
Upcoming Tax Events:
The taxpayer claimed a foreign tax credit with respect to the Japanese taxes. In
A Basic Introduction to China 2006, the Korean tax authorities audited the taxpayer and determined that a
Tax, M&A and Structure portion of the royalties paid by P&G NEA was attributable to Korean sales and
Considerations thus subject to a Korean withholding tax of 15 percent (as well as a 1.5 percent
local surcharge), even though P&G NEA had no physical location or employees
Webinar
April 26, 2011
in Korea.
State and Local Tax Roundtables The taxpayer engaged a prominent Korean law firm and received a legal opinion,
State Limitations on Transfer which concluded that the Korean tax was properly assessed under both Korean
Pricing: Other Current tax law and the US-Korea Income Tax Treaty. The opinion further advised that
Developments any challenge would be unlikely to succeed. Based on this advice, the taxpayer
Dallas determined that there was no reasonable basis for disputing the Korean
April 26, 2011 assessment or invoking the competent authority procedures under the US-Korea
Income Tax Treaty and instead paid the tax. The taxpayer then filed a refund
Houston claim with the IRS requesting an additional foreign tax credit for the Korean taxes
April 27, 2011 paid. The IRS disallowed the credit on the grounds that the taxpayer had failed
Focus on Japan: Coping with the to exhaust all effective and practical remedies. In response, the taxpayer filed
Business and Legal Aftershocks suit in District Court.
Webinar Series The court began by explaining that the exhaustion requirement is a “core
April - May 2011 component” of the foreign tax credit system. Its absence would create a “moral
2011 European Tax Seminar hazard,” the court continued, as “[t]axpayers would have no incentive to
challenge any foreign tax whether or not properly imposed, thereby leaving the
London, England United States to foot the bill through the credit system.” In the case at bar, the
May 18, 2011 court held that the taxpayer should have sought a redetermination of its
BNA/Baker & McKenzie Transfer Japanese tax or invoked competent authority proceedings regarding its
Pricing Conference Japanese tax liability. Thus, while Korea and Japan may ultimately uphold their
claims on the same item of income, the court noted that the “onus” was on the
Washington, DC taxpayer to exhaust all effective and practical remedies in both countries before
June 8-9, 2011 claiming a foreign tax credit. The court required that the taxpayer “at least
Tax Planning & Transactions investigate the possibility of challenging these claims.” Although the taxpayer
Workshop had consulted with Korean counsel, the court pointed out that the taxpayer had
not obtained any advice from Japanese counsel, implying that, had the taxpayer
New York, NY obtained a similarly adverse opinion with respect to the possibility of challenging
June 24, 2011 its Japanese tax liability, the exhaustion requirement would have been fulfilled.
Global Transfer Pricing Thus, the court held, on a summary judgment motion, that the taxpayer was
Workshop entitled to a foreign tax credit only in the amount of the withholding tax payments
it made to Korea, and the taxpayer could not also claim additional credit in the
Bellevue (Seattle), WA amount of the withholding tax payments it made to Japan. Given the fact that the
July 22, 2011 taxpayer had already received a tax credit for its Japanese taxes, the court
mandated that the taxpayer’s credit for Korean taxes be reduced by the amount
already allowed as a credit for Japanese taxes.
In addition to its success in Procter & Gamble, the IRS has recently warned
taxpayers and practitioners more broadly that it would be closely scrutinizing
foreign tax credit claims to ensure that the exhaustion requirement is met. On
February 16, 2011, Michael Danilack, Deputy Commissioner (International) of the
IRS Large Business and International Division, spoke at a Tax Policy Institute
Conference regarding foreign tax credits. Danilack emphasized the IRS’ concern
that claimed foreign tax credits be “legitimate” and indicated that the IRS would
be asking multinational taxpayers “more serious questions” about its credits than
it had in the past. Danilack specifically mentioned that the IRS would be
examining whether “administrative remedies have been exhausted before those
credits are taken.” See Tamu N. Wright, Cross-Border Taxation: Danilack Invites
2 Tax News and Developments April 2011
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Competent Authority Calls, Warns IRS Scrutinizing Foreign Tax Credits, Daily
Tax Report, 33 DTR G-4 (Feb. 17, 2011).
Unfortunately, with foreign tax authorities throughout the world facing depleted
coffers, the situation faced by the taxpayer in Procter & Gamble is not unique,
and multinationals often find themselves subject to competing tax claims on the
same items of income. Procter & Gamble illustrates the critical role that
competent authority can play in resolving such multi-jurisdictional disputes.
Moreover, the exhaustion requirement mandates that taxpayers at least
investigate the involvement of competent authority as well as other potential
remedies in each affected jurisdiction prior to claiming a foreign tax credit.
Perhaps one comfort that taxpayers can draw from Procter & Gamble is that a
legal opinion from a foreign advisor concluding that a challenge to the
assessment is unlikely to be successful will ordinarily satisfy the exhaustion
requirement for that jurisdiction, and a court will generally not require the
taxpayer to pursue costly overseas litigation with little chance of success. With
the convergence of increased audit and assessment activity by foreign tax
authorities and the IRS’ invigorated focus on the foreign tax credit exhaustion
requirement, the tax departments of multinational taxpayers have yet another tax
issue to monitor on top of their already lengthy list.
By Daniel V. Stern, Washington, DC
California Court Treats Copyright Royalties as
Income from Tangible Property in Microsoft Case
The San Francisco Superior Court recently denied Microsoft Corporation’s
(“Microsoft”), claim for refund of over $30 mil in franchise (income) taxes plus
applicable interest and penalties imposed by the California Franchise Tax Board
(“FTB”). Microsoft Corp. v. FTB, Case No. CGC 08-471260 (Feb. 17, 2011).
The case involved four issues:
1. Whether Microsoft’s receipts from licensing its proprietary computer
software to original equipment manufacturers (OEMs) was income from
tangible property or intangible property?
2. Whether receipts from Microsoft’s Treasury operations should be
excluded from the denominator of Microsoft’s sales factor?
3. Whether the standard apportionment formula should be modified to
include the value of Microsoft’s intangible property?
4. Whether the FTB was statutorily and constitutionally authorized to
assess the amnesty penalties against Microsoft?
Two of these were issues of first impression in California: whether software
licensing income gives rise to income from tangible or intangible property and
whether intangible property should be included in the property factor for a
company like Microsoft where the value of intangible property exceeds that of
tangible property.
During tax years ending 1995 and 1996 (“Periods at Issue”), Microsoft’s business
activities included manufacturing, distributing, and licensing its proprietary
computer software to OEMs. Microsoft’s licensed software products were carried
on “Golden Master” disks, which licensees used to copy Microsoft’s software
3 Tax News and Developments April 2011
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onto hard drives on computers they built and sold and back-up disks included
with the assembled computer units. The Microsoft license gave OEMs the right
to install Microsoft software into OEM computer systems and sell those
computers with the pre-installed software.
Income from Copyright Rights
In this case, Microsoft argued that its royalty income constituted receipts from the
licensing of something “other than tangible personal property,” i.e., intangible
property (“IP”). As such, the income should be sourced under California’s “costs-
of-performance” method. Cal. Rev. & Tax Code Section 25136. Under this
method, Microsoft’s IP royalties would be sourced entirely to Washington, where
the majority of the IP’s income-producing activity took place, thus significantly
reducing Microsoft’s California franchise tax liability. The court rejected
Microsoft’s argument, holding that the royalties constituted receipts from the
licensing of tangible as opposed to intangible personal property, and thus should
be sourced to California if the licensed property is located in the state. Cal. Code
Regs. 25136(d)(2)(B). Pointing to the “Golden Master” disk format, the court
stated that “the computer software licensed by Microsoft was inextricably
intertwined with the disks on which they were embedded” and therefore “the
royalties from the licensing of such programs should be classified as deriving
from the sale of tangible personal property.”
In reaching this conclusion, the Trial Court relied primarily on sales tax cases
treating the sale of canned software as tangible property along with other
authorities classifying the transfer of software to an end user as a transaction
involving tangible personal property. The Trial Court failed to cite any authorities
dealing with the license of copyright rights, such as the right to reproduce
involved in Microsoft’s case. The federal tax regulations in Treas. Reg. § 1.861-
18, distinguishing between a copyrighted article and a copyright right, were
summarily dismissed by the Trial Court as “unpersuasive.” The Court failed to
grasp the fundamental distinction between tangible objects and intangible rights.
Treasury Receipts
Microsoft also protested the FTB’s exclusion of total gross receipts from the sale
or disposition of marketable securities from its sales factor denominator. In
making its adjustment, the FTB sought to modify the standard three-factor
apportionment formula, pursuant to Cal. Rev. & Tax Code Section 25137.
Microsoft’s marketable securities were handled by its Treasury Department in
Washington, and any sales or dispositions occurred entirely out-of-state. Under
the standard apportionment formula, such total gross receipts would have
increased the size of Microsoft’s sales factor denominator without affecting its
numerator, thus significantly reducing its California franchise tax liability. The
court upheld the FTB’s use of a modified three-factor-formula, holding that only
net receipts from the marketable securities should be included in Microsoft’s
sales factor. In so doing, the court largely followed the reasoning of prior
decisions in Microsoft Corp. v. Franchise Tax Board, 39 Cal. 4th 750 (Cal. 2006)
and Limited Stores, Inc. v. Franchise Tax Board, 152 Cal. App. 4th 1491 (Cal.
2007).
4 Tax News and Developments April 2011
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Property Factor Modification
The court also rejected Microsoft’s argument that the three-factor apportionment
formula should be modified to include the value of Microsoft’s IP. Microsoft
sought modification under section 25137, arguing that the failure to include IP in
its property factor unfairly reflected the extent of Microsoft’s California business
activity. Clearly, Microsoft’s IP represents a major business income producing
asset that is core to its business. The court rejected this argument, holding that
Microsoft failed to establish by clear and convincing evidence that modification
was warranted.
Penalties
Finally, the court also upheld the imposition of amnesty penalties, imposed
pursuant to Cal. Rev. & Tax Code Section 19777.5. Microsoft argued that the
penalty statute was void because it operated retroactively, was unconstitutionally
vague, and did not provide an opportunity for administrative or judicial pre-
payment or post-payment review. Instead, the court held that the statute did not
operate retroactively, as it did not increase the amount of a taxpayer’s underlying
tax liability, but rather increased “the consequences of not paying the proper
amount for the years at issue within the dictates of the amnesty program.” The
court also held that the amnesty penalty statute was not vague as applied to
Microsoft, and there was adequate opportunity for pre-payment and post-
payment review.
Significance of Case
In practice, the FTB has long treated end-user software, even when delivered
electronically, as tangible personal property, and a few taxpayers have received
informal written statements from the FTB confirming this position. However, we
are not aware of previous instances where the FTB publicly staked out the
position that the license of copyright rights produced income from tangible
property for apportionment purposes. The impact of the court’s decision
depends on the location of the taxpayer. Classification as income from tangible
property is helpful to California-based software companies licensing to out-of-
state unrelated parties who reproduce and distribute the software. Conversely
this classification results in higher California apportionment for out-of-state
software licensors licensing to California based OEMs, like Microsoft. If
California switches from elective to mandatory single sales factor, the effects of
this decision will be doubly important (and disadvantageous) for out-of-state
software licensors. At the time this article was written, Microsoft had not
announced whether it will appeal the decision.
By Scott L. Brandman, New York, J. Pat Powers, Palo Alto
and Sahang-Hee Hahn, New York
5 Tax News and Developments April 2011
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The Ralphs Grocery Decision Restricts the Ability
of Creditors to be Considered Equity Owners for
Purposes of the Continuity of Interest Doctrine
Judge Chiechi of the Tax Court recently issued a surprising decision in Ralphs
Grocery Co. v. Commissioner, T.C. Memo 2011-25, significantly limiting the
ability of creditors of a bankrupt company to qualify as equity owners of the
company for purposes of the continuity of interest (“COI”) doctrine. The Tax
Court, strictly interpreting the facts in Helvering v. Alabama Asphaltic Limestone
Co., 315 U.S. 179 (1942), held that creditors of a bankrupt company must have
“effective command” over the property of the company for the creditors to qualify
as equity owners in the company. The strict requirements of Ralphs Grocery
could thus limit the number of pre-1998 (and possibly post-1997) bankruptcy
reorganizations that can be structured as nontaxable reorganizations.
In Ralphs Grocery, Federated Stores, Inc. (“FSI”) was the domestic parent of a
consolidated group of corporations. FSI held all of the outstanding stock of
Holdings III, Inc. (“Holdings III”). Holdings III, in turn, indirectly held all of the
outstanding stock of Allied Stores Corp. (“Allied”) and directly held 83.75% of the
outstanding stock of Ralphs Grocery Co. (“Ralphs”). Allied held the remaining
16.25% of the outstanding stock of Ralphs.
In 1990, FSI and Allied filed petitions under Chapter 11 of the Bankruptcy Code.
At no time did Ralphs file a petition. In 1992, the bankruptcy court confirmed a
Chapter 11 bankruptcy plan (the “Plan”) proposed by FSI and Allied. Pursuant to
the Plan, a newly formed domestic company, Ralphs Holding Co., Inc. (“RHC”),
acquired all of the outstanding common stock of Ralphs from Holdings III and
Allied (83.75% and 16.25% of the Ralphs common stock, respectively). In
exchange for the Ralphs stock, RHC issued to Holdings III and Allied 83.75%
and 16.25%, respectively, of its outstanding common stock. Thereafter, Holdings
III transferred all of its RHC stock to FSI’s creditors, and Allied transferred 9.65%
of its RHC stock to its creditors (the “Ralphs Transaction”). RHC and FSI filed a
joint election under Code Section 338(h)(10) with respect to RHC’s acquisition of
the common stock of Ralphs from Holdings III and Allied, thereby stepping up the
basis of Ralph’s assets.
The IRS asserted that the Ralphs Transaction qualified as a nontaxable
reorganization under Code Section 368(a)(1)(B), (C) or (G), and that
consequently RHC had a carryover basis under Code Section 362 in the Ralphs
common stock it received. For the Ralphs Transaction to qualify as a nontaxable
reorganization, the non-statutory COI doctrine must also be satisfied in addition
to the statutory requirements under section 368. The COI doctrine generally
requires that a target corporation’s shareholders must have a continuing interest
in the acquiring corporation. Under pre-1998 law, relevant for the Ralphs
Transaction that occurred in 1992, transitory ownership in the acquiring
corporation by the target’s shareholders was disregarded in determining whether
the COI requirement was satisfied. See, e.g. Penrod v. Commissioner, 88 T.C.
1415, 1427 (1987); Heintz v. Commissioner, 25 T.C. 132, 142-143 (1955). As
part of the Plan, assuming the Ralphs Transaction satisfied the statutory
requirements of section 368(a)(1)(C) or (G), the historic shareholder (FSI) of the
target (Holdings III) disposed of its interest in the acquiring corporation (RHC) to
the creditors of FSI. The disposition of the RHC stock thus caused the Ralphs
Transaction to fail the COI requirement under pre-1998 law.
6 Tax News and Developments April 2011
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The COI doctrine would be satisfied, however, if the creditors were considered
equity owners under Alabama Asphaltic. The parties stipulated (the critical
litigating mistake of the IRS) that it was material to the Supreme Court’s holding
in Alabama Asphaltic that the COI requirement would be satisfied if the creditors
“had effective command over the disposition of the property.” The Tax Court
reasoned that the creditors in Alabama Asphaltic had “effective command”
because they took the necessary steps to enforce their rights to “exclude
stockholders [of the bankrupt corporation] entirely from the reorganization plan”
by instituting involuntary bankruptcy proceedings. In Ralphs Grocery,
conversely, FSI filed a voluntary (and not involuntary) petition for bankruptcy.
Moreover, FSI operated as a debtor in possession at all times during the FSI
bankruptcy proceedings. The creditors did not ask the bankruptcy court to
appoint a trustee, nor did it object to FSI operating as a debtor in possession.
Lastly, FSI filed with the bankruptcy court the proposed Plan, and the FSI
creditors never objected to or rejected that proposed Plan.
The Tax Court also considered the Alabama Asphaltic progeny, see e.g., Palm
Springs Holding Corp. v. Commissioner, 315 U.S. 185, 188-189 (1942); Wells
Fargo Bank & Union Trust Co. v. United States, 225 F.2d 298, 300-301 (9th Cir.
1955), noting that the creditors in those cases took proactive steps to enforce or
protect their rights in the bankrupt corporations’ properties, such as filing a
foreclosure action under mortgages securing the bankrupt corporations’ debt,
selling the bankrupt corporations’ assets under an indenture, filing a receivership
action against the bankrupt corporation, or entering into possession and
operating the property of the bankrupt corporation. The creditors of FSI in
Ralphs Grocery did not take any of these proactive steps. The Tax Court thus
concluded that the Ralphs Transaction did not squarely fit under the facts in
Alabama Asphaltic and its progeny, and thus the creditors could not be
considered equity owners.
The effect of Ralphs Grocery on post-1997 bankruptcy reorganizations remains
unclear. First, for reorganizations occurring after January 28, 1998, Treas. Reg.
§ 1.368-1(e)(1) permits historic target shareholders to dispose of their interest in
the acquiring corporation without violating the COI requirement. Subject to
substance-over-form or other anti-abuse judicial doctrines, historical
shareholders of the bankrupt corporation could thus transfer the stock of the
reorganized bankrupt corporation to its creditor(s) and still meet the COI
requirement. However, for a creditor that receives stock of a reorganized
bankrupt corporation in exchange for its debt claims directly from the reorganized
bankrupt corporation (and not the historic shareholders), Ralphs Grocery
arguably applies. Second, the IRS promulgated regulations, effective for
bankruptcy reorganizations occurring on or after December 12, 2008, addressing
whether creditors count positively towards the COI requirement. Under Treas.
Reg. § 1.368-1(e)(6), if any creditor receives a proprietary interest in the
reorganized bankrupt corporation in exchange for its claim, every claim of that
class of creditors, and every claim of all equal and junior classes of creditors is a
property interest. What remains unclear is whether the “effective command”
requirement under Ralphs Grocery is an additional requirement to the 2008
regulations.
To the extent Ralphs Grocery applies to any post-1997 bankruptcy
reorganization, creditors will be required to take the necessary formalistic steps
to assert their control over the bankrupt corporation’s assets, including placing
the debtor in involuntary bankruptcy and requesting the bankruptcy court to
appoint a trustee. These requirements could severely restrict the number of
bankruptcy reorganizations that could qualify as nontaxable reorganizations.
By Elizabeth A. Lieb, Palo Alto
7 Tax News and Developments April 2011
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Chief Counsel Advice Adds More Confusion to
Questions Regarding Place of Use of Intangibles
On October 13, 2010, the IRS Office of Chief Counsel issued Chief Counsel
Advice 201106007 (the “CCA”), addressing whether the sale of software
products by a controlled foreign corporation (“CFC”) into the US market gave rise
to an investment in US property for purposes of Code Section 956(c)(1)(D). In
general, a CFC is treated as holding an investment in US property for purposes
of section 956 if it has any right to use in the United States a copyright which is
acquired or developed by the CFC for use in the United States. Thus, in the
case of a CFC that has rights with respect to software, it is necessary to
determine where the underlying copyright rights are “used” to determine whether
the CFC has made a section 956 investment in US property. The subject matter
of the CCA is of particular interest given the muddled state of existing US tax law
regarding the place of use of intangible property, which has relevance under
sections 956, 861 and 954 (among others). Unfortunately, however, the CCA is
not particularly helpful in resolving or shedding light on the inconsistencies in the
existing case law and IRS guidance on the place of use of intangibles.
The taxpayer involved in the CCA was a US entity that distributed information
technology products and services. The taxpayer developed software in the
United States under a cost-sharing agreement (“CSA”) with its wholly-owned
foreign subsidiary, a CFC. The CSA was somewhat unusual in that the foreign
subsidiary obtained the rights to exploit copyrights in the United States. When a
newly-developed software product was ready for sale to end-user customers, the
taxpayer first transferred the final version of the software code to a “gold master”
disk which was sent to the subsidiary. The subsidiary then reproduced and sold
copies of the software to end-user customers in the United States.
The CCA reached three conclusions, with virtually no discussion of the
underlying reasoning: (1) the foreign subsidiary made an investment in US
property for purposes of section 956 when it acquired or developed the rights to
use the copyrights in the United States under the CSA; (2) the actual sales of
software copies to US customers were not in themselves an investment in US
property; and (3) the transfer of software copies to US customers did not affect
the calculation of the amount includible under section 956 on account of the
subsidiary’s initial investment in US property because the CFC did not acquire or
develop any additional, or relinquish any, rights to use the software rights in the
United States as a result of selling the software copies to US end-users.
Although the CCA neither provides the reasoning nor refers to any case law or
prior administrative guidance to support its conclusions, its first (and most
interesting) conclusion could only follow from the determination that the CFC had
acquired the right to use the copyright in the United States with the intent to use
such right in the United States. Thus, the CCA implicitly provides that acquisition
of a copyright right that permits the CFC to reproduce offshore and sell software
copies to US customers is the use of a copyright in the United States.
In reaching its conclusion in the CCA, the IRS appears to have followed the
reasoning it took in the so-called “textbook ruling” or Rev. Rul. 72-232, 1972-1
C.B. 276 for determining the place of use of intangible property for sourcing
purposes. In that ruling, a US publisher paid royalties to a nonresident for the
right to print books and sell them outside the United States. The IRS ruled that
although the books were printed in the United States, the royalties were entirely
foreign source because “there [was] no commercial publication of the textbooks
8 Tax News and Developments April 2011
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within the United States in that the textbooks [were] not sold within the United
States.” Although, from a legal perspective, the printing of the books in the
United States could not have been undertaken without a license of the US
copyright rights, the IRS focused only on where the books were sold in
determining where the copyrights were used for purposes of sourcing the
royalties. Thus, the ruling suggests that intangible property is “used” for US tax
purposes where the customers for the product are located.
Notably, however, the IRS’s approach in the CCA is at odds with its own prior
guidance in the software sale context which looked to the location of the
licensee’s actual commercial activities with respect to the licensed intangibles to
determine where such intangibles are used. In FSA 200222011, the IRS
National Office advised that a royalty should be treated as wholly from US
sources because the licensee performed its commercial activities related to the
software in the United States. In that advice, a US company licensed the
exclusive worldwide (except Country X) rights to sell, use, copy, manufacture or
sublicense computer software from its Country X parent. The licensee’s software
ultimately was sold to users both within and without the United States. The
National Office did not look to where the ultimate customers were located in
determining where the copyrights were used, but focused instead on the location
of the licensee’s business activities. Unfortunately, the field service advice did
not reference or distinguish the textbook ruling or any other authority, nor did it
explain why it reached a contrary result.
The CCA is also inconsistent with relevant case law. In Sanchez v.
Commissioner, 6 T.C. 1141 (1946), aff’d, 162 F.2d 58 (2d Cir. 1947), the Tax
Court held that the patent royalties were sourced by reference to the location of
the payor’s business activities, and not by reference to where the products were
ultimately consumed or which country’s laws protected the sale and use of the
patented processes. Similarly, in Sabatini v. Commisioner, 32 B.T.A. 705 (1935),
aff’d on this point, 98 F.2d 753 (2d Cir. 1938), the Board of Tax Appeals
determined that a US licensee’s copyright royalty payments to a foreign person
were from US sources where the publication and printing occurred in the United
States, even though some of the rights related to the non-US markets.
In sum, the CCA neither provides any useful rationale to support its conclusion
nor attempts to address the inconsistencies in the IRS’ approach to determine
the place of use of copyrights where a CFC sells software to US end-users but
performs all of its actual operations outside the United States. Taxpayers are
thus left to sort through existing legal authorities and erratic IRS approaches in
determining where intangible property is used for US tax purposes.
For further discussion regarding Chief Counsel Advice 201106007, see Gary D.
Sprague’s upcoming article Section 956 Aspects of the Right to Duplicate and
Sell Software in the US – a Wisp of Guidance from the Service, to be published
in the May 2011 edition of Tax Management International Journal.
By Diana B. Lathi and Paula R. Levy, Palo Alto
9 Tax News and Developments April 2011
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Federal Circuit Upholds Regulation Extending Six
Year Statute of Limitations to Overstated Basis
In Grapevine Imports, Ltd. v. United States, No. 2008-5090 (Fed. Cir. Mar. 11,
2011), the Federal Circuit considered whether the normal three-year statute of
limitations applied to time-bar 2004 administrative adjustments made to a 1999
partnership return on the grounds that the taxpayers had overstated their basis in
certain assets via a tax shelter. The Code extends the period of limitations to
adjust a return when the return “omits” certain items that should have been
included in gross income. The IRS argued that the overstatement of basis in
certain capital assets via a tax shelter constituted an omission of income
sufficient to trigger the extended, six-year limitations period. See Code Sections
6501(e)(1)(A), 6229(c)(2) (2004). The taxpayers countered that the normal
three-year statute of limitations governed the IRS’ Final Partnership
Administrative Adjustment (“FPAA”) and that the adjustments were therefore
time-barred under sections 6501(a) and 6229(a). See section 6501(a) (2004)
(stating the general rule that the IRS may not assess tax more than three years
after the taxpayer’s return); id. section 6229(a) (2004) (reflecting the three-year
limitations rule for tax attributable to partnership items). The Grapevine Court of
Federal Claims relied upon the Supreme Court’s opinion in Colony, Inc. v.
Commissioner, 357 U.S. 28 (1958), which held that under the precursor statute,
overstatement of basis was not an omission from gross income and did not
therefore trigger the extended limitations period. Grapevine Imports, Ltd. v.
United States, 77 Fed. Cl. 505 (2007).
At issue in Grapevine before the Federal Circuit was whether the government
could invoke recently issued Treasury regulations to extend the limitations
period, when judicial precedent limited the IRS’ ability to extend the limitations
period. In Salman Ranch Ltd. v. United States, 573 F.3d 1362 (Fed. Cir. 2009),
another panel of the Federal Circuit determined that the Colony holding was not
limited to the context of income from the sale of goods or services by a trade or
business. Accordingly, Salman Ranch concluded that overstatement of basis did
not constitute an omission from gross income to trigger the extended six-year
limitations period. Shortly after Salman Ranch was issued, the US Department
of Treasury issued new regulations that disputed the Federal Circuit’s reasoning,
stating that Treasury and the IRS disagreed that the Supreme Court’s reading of
the predecessor to section 6501(e) in Colony applied to sections 6501(e) and
6229(c)(2). 75 Fed. Reg. 78,897 (Sept. 28, 2009).
In T.D. 9511, the IRS finalized these temporary regulations, which define an
omission from gross income for purposes of the six-year statute of limitations for
tax assessment set forth under sections 6229(c)(2) and 6501(e)(1)(A). The final
regulations provide that the six-year limitations period for tax assessment applies
to an overstatement of basis in a sold asset that results in an omission from
gross income exceeding twenty-five percent of the income stated in the
taxpayer’s tax return. Under Treas. Reg. § 301.6501(e)-1(a)(iii), “gross income,”
as it relates to any income other than from the sale of goods or services in a
trade or business, has the same meaning as provided under Code Section 61(a).
In the case of amounts received from the disposition of property, gross income
equates to the excess of the amount realized from the disposition of property
over the unrecovered cost of basis of the property. Consequently, under the final
regulations, an overstatement of basis that results in an understatement of
income constitutes an omission from gross income for the purposes of section
6501(e)(1)(A)(i) to which the extended six-year limitations period applies.
10 Tax News and Developments April 2011
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The final regulations were made retroactively effective for all tax years for which
the six-year limitations period for assessing tax was open on or after September
24, 2009. Treas. Reg. § 301.6501(e)-1 (2010). Consequently, the new six-year
limitations period provided in the final regulations effectively reopens tax years
ordinarily closed under the ordinary three-year statute of limitations.
On December 17, 2004, the IRS issued an FPAA that reduced the partners’
basis in Grapevine by $10 million for 1999, necessitating a recomputation of the
partners’ tax liability. Grapevine challenged the adjustment as untimely, arguing
that the appropriate statute of limitations for such adjustments was three years
under section 6501(a) (2004). Conversely, the government argued that
Grapevine’s overstatement of basis – which led to understatement of gain and
consequent underpayment of tax – triggered an extended six-year statute of
limitations under section 6501(e)(1)(A) such that the adjustment was not time-
barred.
To determine whether it was bound by the prior precedential decision in Salman
Ranch, the Federal Circuit considered what amount of deference it owed the
intervening controlling authority reflected in the Treasury Department’s newly
issued regulations. The court dismissed Grapevine’s argument that it was an
abuse of discretion to retroactively apply the 2010 final regulations to a 1999 tax
assessment. Relying on Mayo Found. for Med. Educ. & Research v. United
States, 131 S. Ct. 704 (2011), the court interpreted the regulations under the
standards set forth under Chevron, which require a court to defer to an agency’s
reasonable interpretation of Congress’s intent in an ambiguous statute. Chevron,
U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837, 843-44 (1984). The
court first found that, while instructive, Colony and Salman Ranch did not resolve
the interpretation of ambiguous provisions of what constituted a “substantial
omission” of income under sections 6501(e) and 6229. Further, because
legislative intent did not elucidate the meaning of the provisions, the court found
that there was room for agency interpretation. Determining that the Treasury
regulations were reasonable, the court concluded that the regulations provided
new intervening authority that required a departure from its own prior opinion in
Salman Ranch.
The panel disagreed with Grapevine’s complaint that the government was “trying
to change the rules in the middle of the game” by issuing the final regulations and
concluded that Treasury’s issuance of regulations during litigation “does not
diminish the Department’s authority, nor its right to have its interpretations, when
promulgated, respected by the judiciary – so long as they are reasonable.” The
Federal Circuit reversed the Court of Federal Claims’ judgment, concluding that
because the statutory language in the new regulations was entitled to deference,
Grapevine’s overstatement of basis constituted an “omission from gross income”
for the purposes of the limitations statute, triggering the extended six-year
limitations period under section 6501(e)(1)(A).
In its conclusion, the Federal Circuit joined the Seventh Circuit in upholding the
final regulations as a reasonable interpretation of section 6501(e)(1)(A). The
Fourth, Fifth, and Ninth Circuits have reached the opposite conclusion. Thus,
Grapevine Imports has exacerbated the intercircuit split between those courts
that have upheld the final regulations’ six-year statute of limitations period and
those courts who have rebuffed the IRS’ attempt to retroactively reopen closed
statutes. Compare Beard v. Commissioner, 2011 U.S. App. LEXIS 1575 (7th Cir.
Jan. 26, 2011), rev’g T.C. Memo 2009-184 (concluding that the six-year
limitations period under section 6501(e)(1)(A) applies to a 25% or greater
omission of gross income attributable to overstating the basis of property, aside
from situations involving a trade or business), with Bakersfield Energy Partners
11 Tax News and Developments April 2011
Baker & McKenzie
LP v. Commissioner, 568 F.3d 767 (9th Cir. 2009); Salman Ranch Ltd. v. United
States, 573 F.3d 1362 (Fed. Cir. 2009); see also, Intermountain Insur. Serv. of
Vail v. Commissioner, 134 T.C. No. 11 (May 6, 2010), appeal docketed, No. 10-
1204 (D.C. Cir.) (concluding that overstatement of basis does not constitute an
omission from gross income for purposes of application of the six-year limitations
period for tax assessment); and Home Concrete & Supply, LLC v. United States,
2011 U.S. App. LEXIS 2334 (4th Cir. Feb. 7, 2011), rev’g 599 F. Supp. 2d 678
(E.D.N.C. 2008); Burks v. United States, No. 09-11061 (5th Cir. Feb. 9, 2011)
(concluding that because the Treasury cannot overturn a court’s holding
concerning plain meaning of statutory language, the 2010 final regulations are
not entitled to Chevron deference under Mayo Foundation, and therefore
overstatement of basis does not constitute an omission from gross income).
The Home Concrete and the Burks cases were discussed in a previous article.
See Tax News and Developments,“Decolonized?” Treasury Promulages Final
Regulations Extending Six-Year Assessment Period to Certain Overstatements
of Basis, Vol. 11, Issue 1, February 2011, available under publications at
www.bakermckenzie.com.
By concluding that regulatory interpretation supersedes precedential judicial
interpretation of ambiguous statutory provisions, the Grapevine Imports case
illustrates that, at least some courts may rely upon Mayo Foundation and
Chevron, as a basis for granting the government great latitude to interpret
ambiguous code provisions and to issue regulations that constitute “new
controlling authority” and contradict judicial precedent.
The panel’s analysis in Grapevine Imports is unsatisfying on a number of levels.
When made, the IRS’ 2004 adjustment to Grapevine’s 1999 return was invalid,
barred by the three-year limitations period that had already run. The application
of the new six-year limitations period provided in the final regulations effectively
grants the IRS a third bite at the apple and reopens tax years ordinarily closed
under the ordinary three-year statute of limitations. Absent recodification of the
statutory language given plain meaning in Colony, the Federal Circuit improperly
concluded that the 2010 final regulations governed the interpretation of statutory
language made unambiguous by a prior Supreme Court interpretation. See
NCTA v. Brand X, 545 U.S. 967 (2005).
By Robert S. Walton and Sonja Schiller, Chicago
Cost-Sharing “Divisional Interests” Rule as Applied
to e-Commerce Business Models
In a recent article, Gary D. Sprague proposes a practical approach to interpreting
the “divisional interests” rule under the 2009 cost-sharing regulations that would
give e-commerce businesses more flexibility in complying with the requirements.
See Gary D. Sprague, Cost-Sharing “Divisional Interests” Rule as Applied to e-
Commerce Business Models, 40 Tax Mgm’t Int’l J. 190 (Mar. 11, 2011) available
under publications at www.bakermckenzie.com.
Under the divisional interests requirement of Treas. Reg. § 1.482-7T(b)(1)(iii) and
(b)(4), each controlled participant in a cost-sharing agreement “must receive a
non-overlapping interest in the cost shared intangibles without further obligation
to compensate another controlled participant for such interest.” The regulations
sanction two ways of dividing interests: by territory and by field of use. In
addition, interests may be divided on some other basis if certain requirements
are met: (1) all interests in cost shared intangibles must be clearly and
12 Tax News and Developments April 2011
Baker & McKenzie
unambiguously divided among the controlled participants, (2) the controlled
participants must be able to verify the consistent use of the basis for the division,
(3) the rights of the controlled participants must be non-overlapping, exclusive,
and perpetual, and (4) the resulting benefits associated with each controlled
participant’s interest in cost shared intangibles must be “predictable with
reasonable reliability.”
The examples in the regulations suggest that this last requirement will be strictly
interpreted, essentially requiring the resulting benefits to be “locked in stone.”
The article argues that Treasury should permit a more flexible approach.
The article considers the example of a business that uses a single cost-shared
software platform to operate a series of websites, each of which focuses on a
distinct subject but attracts subscribers from around the world. The article
proposes that a division of rights that allocates to each participant the right to
exploit the market through specified sites should be respected as satisfying the
“predictable with reasonable reliability” requirement. Such a division
accomplishes the primary purpose of the divisional interests rule, which is to
prevent taxpayers from gaming the system by cost sharing based on one set of
assumptions about the expected benefits and then intentionally shifting
exploitation from one party to another to change their relative benefits. For
instance, a taxpayer that operates separate sites for ballet lovers and hip-hop
fans will not easily be able to shift customers from one site to the other.
This approach acknowledges the differences between e-commerce and more
traditional businesses involving the manufacture and sale of tangible property. In
the e-commerce context, there will be many cases where neither a territorial nor
a field-of-use division will make sense; the proposal offers a workable alternative.
Furthermore, a more flexible reading of the divisional interests rule should not
harm the interests of the Treasury because the cost sharing regulations already
include sufficient safeguards to ensure that parties are compensated on an arm’s
length basis for any change in expected benefits.
By Paula R. Levy, Palo Alto
Proposed Regs Would Require US Financial
Institutions to Report Bank Deposit Interest
Income for all Non-Resident Alien Individuals
Under Code Section 871(i)(2), non-resident alien individuals are exempted from
US taxation on the receipt of non-effectively connected interest income from
amounts deposited with certain domestic financial institutions, including banks,
savings institutions, and amounts held by insurance companies (“Bank Deposit
Interest Income”). Additionally, under Treas. Reg. § 1.6049-8(a), these domestic
financial institutions are not required to report the amount of Bank Deposit
Interest Income earned by non-resident alien individuals, with the exception of
amounts paid to Canadian residents (and amounts paid to US tax residents). The
exemption from tax and reporting has been a part of the Internal Revenue Code
for over 50 years. See former Code Section 861(a)(1)(A) [12/31/1954]. At the
time it was understood that Congress’ intent was to provide an incentive for non-
resident alien individuals to bank in the United States.
On January 7, 2011, the Treasury issued proposed regulations (Prop. Reg. §
1.6049-8) that would require US financial institutions to annually report Bank
Deposit Interest Income of all non-resident individuals to the IRS (“2011
13 Tax News and Developments April 2011
Baker & McKenzie
Baker & McKenzie Proposed Regulations”). It should be noted that these new rules affect only
North America Tax reporting requirements and do not affect the taxation of Bank Deposit Interest
Income. The 2011 Proposed Regulations are similar to proposed regulation that
Chicago
were issued 2001, which never became effective but would have required
+1 312 861 8000
domestic financial institutions to report bank deposit interest income earned by all
Dallas non-resident alien individuals to the IRS. In response to strong opposition, the
+1 214 978 3000 Treasury withdrew the 2001 Proposed Regulations and issued revised proposed
regulations, which would have limited the scope of the reporting by domestic
Houston financial institutions to residents of only 15 countries (the (“2002 Proposed
+1 713 427 5000 Regulations”). The 2002 Proposed Regulations never became effective and have
been replaced by the 2011 Proposed Regulations, which essentially reinstated
Miami
the 2001 Proposed Regulations.
+1 305 789 8900
The 2011 Proposed Regulations were released in close time proximity to the
New York
+1 212 626 4100 Foreign Account Tax Compliance Act of 2010 (“FATCA”), which generally
provided for increased information exchange by foreign financial institutions that
Palo Alto hold financial accounts of US taxpayers. The preamble to the 2011 Proposed
+1 650 856 2400 Regulations provides two reasons for the extended scope of reporting:
San Francisco First, since the 2002 proposed regulations were released,
+1 415 576 3000 there is a growing global consensus regarding the importance
of cooperative information exchange for tax purposes that has
Toronto developed. Significant agreements have been reached on
+1 416 863 1221 international standards for the exchange of information,
Washington, DC including, for example, the understanding that information
+1 202 452 7000 exchange will not be limited by bank secrecy or the absence of
a domestic tax interest. Second, requiring routine reporting to
the IRS of all U.S. bank deposit interest paid to any
nonresident alien individual will further strengthen the United
States exchange of information program, consistent with
adequate provisions for reciprocity, usability, and
confidentiality in respect of this information. Finally, this
extension will help to improve voluntary compliance by U.S.
taxpayers by making it more difficult to avoid the U.S.
information reporting system (such as through false claims of
foreign status).
Under Prop. Reg. § 1.6049-8(a), the domestic financial institution may rely on a
valid Form W-8BEN to determine whether the payment is made to a non-resident
alien individual. Prop. Reg. § 1.6049-6(e)(4) clarifies that Bank Deposit Interest
Income should be reported on a Form 1042-S, “Foreign Person’s U.S. Source
Income Subject to Withholding.” Furthermore, Prop. Reg. § 1.6049-6(e)(4) states
that Form 1042-S should be furnished to the recipient by either providing it
directly to the recipient or mailing it to the last known address of the recipient.
The 2011 Proposed Regulations are to become effective on Bank Deposit
Interest Income payments made after December 31 of the year in which they are
published as final regulations in the Federal Register. The Preamble provides
that the Treasury believes that the 2011 Proposed Regulations will not have a
significant impact on a substantial number of small entities because depository
accounts tend to be deposited with larger financial institutions and banks are
already required to gather the underlying information on Forms W-8 when
individuals initially open bank accounts. However, the IRS has requested
information regarding the economic impact of the 2011 Proposed Regulations on
small commercial banks, savings institutions, credit unions, and small securities
brokerages.
By Steven Hadjilogiou and Daniel W. Hudson, Miami
14 Tax News and Developments April 2011
Baker & McKenzie
www.bakermckenzie.com
First Annual BNA/Baker & McKenzie Transfer
Pricing Conference to be held June 8-9 in
Baker & McKenzie Washington, DC
Global Services LLC
One Prudential Plaza,
This summer, Baker & McKenzie teams with BNA to offer their first annual
Suite 2500
130 East Randolph Drive Transfer Pricing Conference where senior government, corporate and private
Chicago, Illinois 60601, USA transfer pricing practitioners will gather to discuss cutting edge transfer pricing
Tel: +1 312 861 8000 issues facing multinational companies today. The one and a half day conference
Fax: +1 312 861 2899 will take place on Wednesday, June 8 and Thursday, June 9, and will feature a
range of topics from the reorganized LB&I and solutions for resolving cross-
border transfer pricing disputes to the new OECD project on the transfer pricing
of intangibles and how recent transfer pricing legislation may impact multinational
companies.
Over 15 US and foreign Baker & McKenzie transfer pricing practitioners will
present at the upcoming conference, along side corporate and government
speakers. Key government speakers include:
Christopher Bello (Chief, Branch 6, Office of Associate Chief Counsel
(International), IRS);
Mary Bennett (Head of Tax Treaty & Transfer Pricing Division, OECD);
Michael Danilack (LB&I Deputy Commissioner (International), IRS);
David Ernick (Associate International Tax Counsel, US Department of
the Treasury);
John Hinding (Director, APA Program, IRS);
Cyndi Lafuente (LB&I, Senior Advisor to the Deputy Commissioner
(International), IRS); and
Caroline Silberztein (Head of Transfer Pricing Unit, OECD)
The brochure containing full conference details, agenda and registration
information is accessible by clicking on this link or visiting BNA online at
www.bnatax.com/transfer-pricing-conference. We hope to see you in
Washington, DC at what promises to be an interesting and informative
conference!
Tax News and Developments is a periodic publication of Baker & McKenzie’s North American
Tax Practice Group. The articles and comments contained herein do not constitute legal advice or
formal opinion, and should not be regarded as a substitute for detailed advice in individual cases.
Past performance is not an indication of future results.
Tax News and Developments is edited by Senior Editors, David G. Glickman (Dallas) and
David R. Tillinghast (New York), and an editorial committee consisting of James H. Barrett
(Miami), Theodore R. Bots (Chicago), Salim R. Rahim (Washington, DC), Michael Snider
(Houston), Angela J. Walitt (Washington, DC), and Beth L. Williams (Palo Alto)
For further information regarding the North American Tax Practice Group or any of the items or
Upcoming Events appearing in this Newsletter, please contact Carol Alexander at +1 312 861 8323
or carol.alexander@bakermckenzie.com.
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15 Tax News and Developments April 2011
